If paying for college is in your future, you might be pondering the idea of enrolling in a 529 college savings plan. If so, you’re not alone. After Obama quickly retracted his proposal to remove their federal tax benefits earlier this year, many families decided the savings tools were worth another look.
But did you know that there are hundreds of plans available and no two are exactly alike? How can you be sure a particular plan will help you reach your savings goal?
How A 529 College Savings Plan Works
If you understand how a Roth IRA works, you should have a pretty good idea about how a 529 college savings plan works. 529 plans are investment accounts designed to help families set aside money for future higher education costs. You make contributions with after-tax money, earnings grow tax-free and the money you withdraw will not be taxed as long as it is used to pay for college.
If you don’t use the funds to pay for college, the earnings portion of your account will incur income taxes and a 10% penalty. The principal portion, which is the amount you put in, will never be taxed or penalized because your contributions were made with after tax money.
The Benefits Over Other College Savings Vehicles
Of course, there are other ways to save for college. You can invest in a Coverdell Education Savings Account or a Roth IRA and get the same tax-free growth. But that’s only if you meet the income requirements. For Coverdells, married couples filing jointly must have a modified gross adjusted income less (MAGI) than $220,000, and for Roth IRAs MAGI must be less than $193,000. What’s more, you can only deposit up to $2,000 per child per year to a Coverdell and up to $5,500 annually to a Roth IRA.
529 plans, on the other hand, are available to families of all income levels and have no annual contribution limits. In fact, grandparents who are married and filing jointly can gift as much as $70,000 in one year and avoid incurring gift taxes if they elect to treat the contribution as if it were made over a five-year period.
Yes, You Can Start Small
Now, some of you saw that $70,000 number and immediately wanted to stop reading this post. Yes, that is a lot of money, but most contributions from young families won’t be anywhere near that amount. Many 529 plans have minimum contribution requirements as low as $25 per month. You can even “set it and forget it” with automatic recurring deposits that are linked to your bank account.
While these modest contributions will add up over time, you probably won’t be able to fund an entire college education this way. To boost your savings, you can ask friends and family members to help fund your plan in lieu of birthday and holiday gifts. More and more plans are making it easy to contribute to a loved one’s 529 plan securely via their website and social media channels.
Let’s say your child is five years old and you can afford to deposit $25 a month in to his 529 plan. When it’s time for college, you’ll have around $5,900, assuming an annual investment return of 6%. But if you also made an initial deposit of $500 using gifts from friends and family when you opened the account, your balance at the end of high school jumps to $7,000, assuming the same investment return.
Your State Might Help
States know that access to higher education can improve the economic well being of their community, which is why many are actively encouraging residents to save for college. In fact, 34 states currently offer a state tax deduction or credit for 529 plan contributions. Most tax breaks are strictly offered to residents who use their home state’s plan, but six of these states will reward residents who save for college with any 529 plan. In addition to tax benefits, states also promote saving for college with incentives such as matching grants for residents who open 529 accounts, hosting community events and scholarship competitions.
Keep in mind, however, that you can enroll in almost any 529 plan no matter where you live, and your plan choice does not determine where your child will have to attend college. So if you live in California, which doesn’t offer any tax breaks for 529 contributions, you can save with New York’s plan and your child can attend the University of Kansas.
Yet, according to Savingforcollege.com’s Annual College Savings Survey, 20% of the 1,600+ parents and grandparents surveyed believe that you have to use your home state’s plan. While it is recommended that you start with your home state’s plan in case there are any benefits offered, you should always shop around. Lower fees or better investment performance found in another state’s plan can outweigh the tax breaks offered by an in-state plan.
How To Find The Best 529 Plan
So with hundreds of options available, how do you know which 529 plan is best for your family’s needs? First, you’ll need to decide whether you want to enroll in a plan directly or consult the help of a financial advisor. You’ll likely end up paying more for an advisor-sold plan, but you could also benefit from their expertise. As mentioned above, if you decide to select an education savings plan on your own, be sure to evaluate the plan’s investment performance and management fees, as well as any tax breaks or other incentives to enroll.
Simply put, the best 529 plan is the one that provides the greatest return on your invested dollars by the time you need the money to pay for college with an acceptable level of investment risk, and gives you the fewest hassles or unpleasant surprises along the way. To narrow down your choices, you can enter information about your family into the College Savings Planner to generate a personalized savings plan designed to suit your specific needs.
Are you taking advantage of a 529 college savings plan?
Kathryn Flynn is content director of Savingforcollege.com. She has worked in the investment industry for over 10 years and brings a wealth of knowledge to her posts. She is a firm believer in the need for financial awareness and enjoys helping families understand the benefits of saving for college with 529 plans. You can follow Kathryn on Twitter at @saving4college and on Facebook.